Cost of capital

Key Concepts & SkillsCalculate & explain

A firm’s cost of common equity capitalA firm’s cost of preferred stockA firm’s cost of debt

A firm’s overall cost of capitalAnalyze & discuss pitfalls of overall cost of

capital & how to manage themPrint out the associated PDF for this PowerPoint

slideshow to use during the show if you want to!You will find that file where you found this video &

slides

Cost of Capital BasicsThe cost to a firm for capital funding

The return to the providers of those fundsThe return earned on assets should depend on the

risk of those assetsIn equilibrium WACC = ROA

A firm’s cost of capital indicates how the market views the risk of the firm’s assets

A firm must earn at least the required return to compensate investors for the financing they have provided

The required return is the same as the appropriate discount rate

IBMSources of data

S&P NetAdvantage Database in the SEU library online

Finance.yahoo.comDate: 11/17/2011

Cost of Common EquityReturn required by equity investors given the

risk of the cash flows from the firmTwo major methods for determining the cost

of equityDividend growth modelCAPM

Dividend Growth Model ApproachStart with the

dividend growth model formula & rearrange to solve for RE

Assumption is that the stock is priced fairly

Does this look familiar?

gP

DR

P

DgR

gR

DP

0

1E

0

1E

E

10

Dividend Growth ModelThe current stock price is $185.27Your company is expected to pay a dividend

of $3.00 per share next yearD1 or D0?

Dividends have grown at a steady rate of 10.00% per year & the market expects that to continueHow long can that really continue?

What is the cost of equity?

%62.110.10000162.00.1000$185.27

$3.00R E

gP

DR

0

1E

Advantages & Disadvantages of Dividend Growth ModelAdvantage

Easy to understand & useDisadvantages

Only applicable to companies currently paying dividends

Not applicable if dividends, earnings, stock price are not growing at a reasonably constant rate

Sensitive to the estimated growth rateDoes not explicitly consider riskRelies on the past to predict the future

The CAPM (SML) ApproachUse the following information to compute the

cost of equityRisk-free rate

Rf

Market risk premium E(RM) – Rf

Systematic risk of asset

fMEfE R)E(RβRR

The CAPM (SML) Approach

Company’s equity beta = 0.49Current risk-free rate = 3.00% Expected market risk premium = 17.00% What is the cost of equity capital?

%33.11.00%1749.03.00%R E

Advantages & Disadvantages of SMLAdvantages

Explicitly adjusts for systematic riskApplicable to all companies, as long as beta is

availableDisadvantages

Must estimate the expected market risk premium

Must estimate betaRelies on the past to predict the future

Cost of preferred stockIf IBM had preferred

stockUse the current price

of the preferred stockAlong with its annual

dividendAnd the constant

growth modelTo estimate its cost of

preferred stockThe growth in

dividends is zero

0P

0

1E

P

DR

stock preferredfor 0g

reflect oequation t Alter the

gP

DR

Cost of DebtThe cost of debt

Required return on a company’s debtWhat is the name for that kind of yield?

Yield to maturity on existing debt

The cost of debt is NOT the coupon rate on OLD or OUTSTANDING DEBT

Cost of DebtOutstanding

bond issue34 years to

maturity Coupon rate

= 7.00%Coupons paid

semiannuallyCurrently

bond price = $1,339.71

What is the YTM?

CLR TVMSet P/Y = 2

N = 34 years x 2 payments per year = 68

PV = -1339.71PMT= (0.0700 x 1000.00)/2 = 35FV = 1000.00CPT I/Y = 4.93%

Cost of DebtUse the YTM on the firm’s debtInterest is tax deductible, so the after-tax

(AT) cost of debt is

If the corporate tax rate = 25.66%

)T(1RR CBTD,ATD,

%66.3)2566.0(1%93.4R ATD,

Weighted Average Cost of CapitalWACCUse the individual (component) costs of

capital to compute a weighted average cost of capital for the firm

This averageThe required return on the firm’s assets, based

on the market’s perception of the risk of those assets

The weights are determined by how much of each type of financing is used

Determining theWeights for the WACCWeights

Proportions of the firm that will be financed by each component

Always use the target weights, if possibleIf not available, use market valuesIf not available, use book values

Capital Structure Weights: MarketFrom observed prices in the marketNotation

E = market value of common equity = # outstanding shares of common shares times price per share

P = market value of preferred stock = # outstanding shares of preferred shares times price per

shareD = market value of debt

= # outstanding bonds times bond price

V = market value of the firm = E + P + DWeights

E/V = proportion financed with common equity P/V = proportion financed with preferred stock D/V = proportion financed with debt

Capital Structure Weights: BookFrom observed balances on the balance sheetNotation

E = book value of common equity = common stock + capital in excess of par + retained

earnings – treasury stockP = book value of preferred stockD = book value of typically only long-term debt

V = book value of the firm = E + P + DCapital structure weights

E/V = proportion financed with common equity P/V = proportion financed with preferred stock D/V = proportion financed with debt

WACC

Capital structure

weights

Component costs before

tax

CDPE T -1RVD RV

P RVE WACC

Where

(E/V) = proportion of common equity in capital structure (P/V) = proportion of preferred stock in capital structure (D/V) = proportion of debt in capital structure

RE = firm’s cost of equity RP = firm’s cost of preferred stock RD = firm’s cost of debt

TC = firm’s corporate tax rate

Estimating WeightsMarket value of common equity Market price of the common stock = $185.27

per share 1,178,766,125 shares common stock

Market value of equity (E) = $185.27 per share x 1,178,766,125 shares= $218,390,000,000 (a little more than $218 B)

Estimating WeightsPreferred stock?

There is none…so P/V = 0

Estimating WeightsBook value of long-term debtAlthough we know the market price per bond of

the long-term debt, we do not have the number of bonds outstanding

So, I will use the book value of long-term debt insteadOk to do if interest rates have not changed or If we do not have all the data from the market

Book value of long-term debt from the balance sheet=$21,932,000,000 (almost $22 B)

Estimating WeightsUsing market value of equity & book value of debt to calculate the weights

AmountsE = $218,390,000,000P = $0D = $21,932,000,000

V = $240,322,000,000Weights

E/V = $218,390,000,000/$240,322,000,000 = 0.9087 or 90.87%

P/V = $0/$240,322,000,000 = 0.0000 or 0.00%

D/V = $21,932,000,000/$240,322,000,000 = 0.0913 or 9.13%

WACCUsing market value of equity & book value of debt to calculate the weights

%10.63

0.33%0.00%10.30%

)2566.01(%93.40.0913

R0.0000

11.33%0.9087

T -1 x RVD RV

P RVE WACC

debt ofcost

tax-after weighted

stock preferred ofcost

tax-after weighted

equitycommon ofcost

tax-after weighted

debt ofcost tax -after%66.3

P

debt ofcost

tax-after weighted

debt ofcost tax -after

CD

stock preferred ofcost

tax-after weighted

P

equitycommon ofcost

tax-after weighted

E

Estimating WeightsUsing book value of equity & book value of debt to calculate the weights

AmountsE = $22,291,000,000P = $0D = $21,932,000,000

V = $44,223,000,000Weights

E/V = $22,291,000,000/$44,223,000,000 = 0.5041 or 50.41%

P/V = $0/$44,223,000,000 = 0.0000 or 0.00%

D/V = $21,932,000,000/$44,223,000,000 = 0.4959 or 49.59%

WACCUsing book value of equity & book value of debt to calculate the weights

%7.53

1.81%0.00%5.71%

)2566.01(%93.40.4959

R0.0000

11.33%0.5041

T -1 x RVD RV

P RVE WACC

debt ofcost

tax-after weighted

stock preferred ofcost

tax-after weighted

equitycommon ofcost

tax-after weighted

debt ofcost tax -after%66.3

P

debt ofcost

tax-after weighted

debt ofcost tax -after

CD

stock preferred ofcost

tax-after weighted

P

equitycommon ofcost

tax-after weighted

E

Weight CostAfter-tax

cost

Weighted after-tax

costWeight Cost

After-tax cost

Weighted after-tax

cost

Debt 9.13% 4.93% 3.66% 0.33% Debt 49.59% 4.93% 3.66% 1.81%

Equity 90.87% 11.33% 11.33% 10.30% Equity 50.41% 11.33% 11.33% 5.71%

Tax rate 25.66% Tax rate 25.66%

WACC 10.63% WACC 7.53%

Using market value of equity & book value of debt to calculate the weights

Using book value of equity & book value of debt to calculate the weights

WACC Table for Calculations

Big difference!

Factors that influence a company’s WACCMarket conditions, especially interest rates,

tax rates & the market risk premiumThe firm’s capital structure & dividend policyThe firm’s investment policy

Firms with riskier projects generally have a higher required return

Risk-adjusted required returnA firm’s WACC reflects the risk of an average

project undertaken by the firmDifferent divisions/projects may have

different risks The division’s or project’s required return

should be adjusted to reflect the appropriate risk & capital structure

WACC may not be appropriate

Using WACC for All Projects

What would happen if we use the WACC for all projects regardless of risk?

Using WACC for All ProjectsDifferent decisions using

WACC = 15% Incorrect decision

A risk-adjusted return accounting for the project cash flow risk Correct decision

Tend to accept projects that are too risky…like project ATend to reject projects that are less risky…like project CThe risk of the firm will increase over time using RR = WACC

Project

Expected return =

IRR

Fixed WACC required

return

Risk-adjusted required

returnDecision using required

return = fixed WACCDecision using required return =

risk-adjusted returnA 17% 15% 20% Accept because ER > RR Reject because ER < RRB 18% 15% 15% Accept because ER > RR Accept because ER > RRC 12% 15% 10% Reject because ER < RR Accept because ER > RR

Correct decision

Incorrect decision

Key Concepts & SkillsCalculate & explain

A firm’s cost of common equity capitalA firm’s cost of preferred stockA firm’s cost of debt

A firm’s overall cost of capitalAnalyze & discuss pitfalls of overall cost of

capital & how to manage them

End of cost of capital